Preferencing, Internalization, Best Execution, and Dealer Profits

The practices of preferencing and internalization have been alleged to support collusion, cause worse execution, and lead
to wider spreads in dealership style markets relative to auction style markets. For a sample of London Stock Exchange stocks,
we find that preferenced trades pay higher spreads, however they do not generate higher dealer profits. Internalized trades
pay lower, not higher, spreads. We do not find a relation between the extent of preferencing or internalization and spreads
across stocks. These results do not lend support to the “collusion” hypothesis but are consistent with a “costly search and
trading relationships” hypothesis.